You run Ford Motor Company. List 3 different costs you have. List 3 different business decisions that are affected by your costs. A C T I V E L E A R N I N G 1 Brainstorming costs 1
In this chapter, look for the answers to these questions: What is a production function? What is marginal product? How are they related? What are the various costs, and how are they related to each other and to output? How are costs different in the short run vs. the long run? What are economies of scale? 2
THE COSTS OF PRODUCTION 3 Total Revenue, Total Cost, Profit We assume that the firms goal is to maximize profit. Profit = Total revenue – Total cost the amount a firm receives from the sale of its output the market value of the inputs a firm uses in production
THE COSTS OF PRODUCTION 4 Costs: Explicit vs. Implicit Explicit costs require an outlay of money, e.g., paying wages to workers. Implicit costs do not require a cash outlay, e.g., the opportunity cost of the owners time. Remember one of the Ten Principles: The cost of something is what you give up to get it. This is true whether the costs are implicit or explicit. Both matter for firms decisions.
THE COSTS OF PRODUCTION 5 Explicit vs. Implicit Costs: An Example You need $100,000 to start your business. The interest rate is 5%. Case 1: borrow $100,000 explicit cost = $5000 interest on loan Case 2: use $40,000 of your savings, borrow the other $60,000 explicit cost = $3000 (5%) interest on the loan implicit cost = $2000 (5%) foregone interest you could have earned on your $40,000. In both cases, total (exp + imp) costs are $5000.
THE COSTS OF PRODUCTION 6 Economic Profit vs. Accounting Profit Accounting profit =total revenue minus total explicit costs Economic profit =total revenue minus total costs (including explicit and implicit costs) Accounting profit ignores implicit costs, so its higher than economic profit.
The equilibrium rent on office space has just increased by $500/month. Compare the effects on accounting profit and economic profit if a. you rent your office space b. you own your office space A C T I V E L E A R N I N G 2 Economic profit vs. accounting profit 7
The rent on office space increases $500/month. a.You rent your office space. Explicit costs increase $500/month. Accounting profit & economic profit each fall $500/month. b.You own your office space. Explicit costs do not change, so accounting profit does not change. Implicit costs increase $500/month (opp. cost of using your space instead of renting it), so economic profit falls by $500/month. A C T I V E L E A R N I N G 2 Answers 8
THE COSTS OF PRODUCTION 9 The Production Function A production function shows the relationship between the quantity of inputs used to produce a good and the quantity of output of that good. It can be represented by a table, equation, or graph. Example 1: Farmer Jack grows wheat. He has 5 acres of land. He can hire as many workers as he wants.
THE COSTS OF PRODUCTION ,000 1,500 2,000 2,500 3, No. of workers Quantity of output Example 1: Farmer Jacks Production Function Q (bushels of wheat) L (no. of workers)
THE COSTS OF PRODUCTION 11 Marginal Product If Jack hires one more worker, his output rises by the marginal product of labor. The marginal product of any input is the increase in output arising from an additional unit of that input, holding all other inputs constant. Notation: (delta) = change in… Examples:Q = change in output, L = change in labor Marginal product of labor (MPL) = Q L
THE COSTS OF PRODUCTION Q (bushels of wheat) L (no. of workers) EXAMPLE 1: Total & Marginal Product MPL Q = 1000 L = 1 Q = 800 L = 1 Q = 600 L = 1 Q = 400 L = 1 Q = 200 L = 1
THE COSTS OF PRODUCTION 13 MPL equals the slope of the production function. Notice that MPL diminishes as L increases. This explains why the production function gets flatter as L increases ,000 1,500 2,000 2,500 3, No. of workers Quantity of output EXAMPLE 1: MPL = Slope of Prod Function MPL Q (bushels of wheat) L (no. of workers)
THE COSTS OF PRODUCTION 14 Why MPL Is Important Recall one of the Ten Principles: Rational people think at the margin. When Farmer Jack hires an extra worker, his costs rise by the wage he pays the worker his output rises by MPL Comparing them helps Jack decide whether he would benefit from hiring the worker.
THE COSTS OF PRODUCTION 15 Why MPL Diminishes Farmer Jacks output rises by a smaller and smaller amount for each additional worker. Why? As Jack adds workers, the average worker has less land to work with and will be less productive. In general, MPL diminishes as L rises whether the fixed input is land or capital (equipment, machines, etc.). Diminishing marginal product: the marginal product of an input declines as the quantity of the input increases (other things equal)
THE COSTS OF PRODUCTION 16 EXAMPLE 1: Farmer Jacks Costs Farmer Jack must pay $1000 per month for the land, regardless of how much wheat he grows. The market wage for a farm worker is $2000 per month. So Farmer Jacks costs are related to how much wheat he produces….
THE COSTS OF PRODUCTION 17 EXAMPLE 1: Farmer Jacks Costs $11,000 $9,000 $7,000 $5,000 $3,000 $1,000 Total Cost $10,000 $8,000 $6,000 $4,000 $2,000 $0 $1, Cost of labor Cost of land Q (bushels of wheat) L (no. of workers)
THE COSTS OF PRODUCTION 18 EXAMPLE 1: Farmer Jacks Total Cost Curve Q (bushels of wheat) Total Cost 0$1, $3, $5, $7, $9, $11,000
THE COSTS OF PRODUCTION 19 Marginal Cost Marginal Cost (MC) is the increase in Total Cost from producing one more unit: TC Q MC =
THE COSTS OF PRODUCTION 20 EXAMPLE 1: Total and Marginal Cost $10.00 $5.00 $3.33 $2.50 $2.00 Marginal Cost (MC) $11,000 $9,000 $7,000 $5,000 $3,000 $1,000 Total Cost Q (bushels of wheat) Q = 1000 TC = $2000 Q = 800 TC = $2000 Q = 600 TC = $2000 Q = 400 TC = $2000 Q = 200 TC = $2000
THE COSTS OF PRODUCTION 21 MC usually rises as Q rises, as in this example. EXAMPLE 1: The Marginal Cost Curve $11,000 $9,000 $7,000 $5,000 $3,000 $1,000 TC $10.00 $5.00 $3.33 $2.50 $2.00 MC Q (bushels of wheat)
THE COSTS OF PRODUCTION 22 Why MC Is Important Farmer Jack is rational and wants to maximize his profit. To increase profit, should he produce more or less wheat? To find the answer, Farmer Jack needs to think at the margin. If the cost of additional wheat (MC) is less than the revenue he would get from selling it, then Jacks profits rise if he produces more.
THE COSTS OF PRODUCTION 23 Fixed and Variable Costs Fixed costs (FC) do not vary with the quantity of output produced. For Farmer Jack, FC = $1000 for his land Other examples: cost of equipment, loan payments, rent Variable costs (VC) vary with the quantity produced. For Farmer Jack, VC = wages he pays workers Other example: cost of materials Total cost (TC) = FC + VC
THE COSTS OF PRODUCTION 24 EXAMPLE 2 Our second example is more general, applies to any type of firm producing any good with any types of inputs.
THE COSTS OF PRODUCTION 25 EXAMPLE 2: Costs $ $0 100 $1000 TCVCFCQ $0 $100 $200 $300 $400 $500 $600 $700 $ Q Costs FC VC TC
THE COSTS OF PRODUCTION 26 Recall, Marginal Cost (MC) is the change in total cost from producing one more unit: Usually, MC rises as Q rises, due to diminishing marginal product. Sometimes (as here), MC falls before rising. (In other examples, MC may be constant.) EXAMPLE 2: Marginal Cost $1000 MCTCQ $70 TC Q MC =
THE COSTS OF PRODUCTION 27 EXAMPLE 2: Average Fixed Cost $100 n/a$1000 AFCFCQ Average fixed cost (AFC) is fixed cost divided by the quantity of output: AFC = FC/Q Notice that AFC falls as Q rises: The firm is spreading its fixed costs over a larger and larger number of units.
THE COSTS OF PRODUCTION 28 EXAMPLE 2: Average Variable Cost $70 n/a$00 AVCVCQ Average variable cost (AVC) is variable cost divided by the quantity of output: AVC = VC/Q As Q rises, AVC may fall initially. In most cases, AVC will eventually rise as output rises.
THE COSTS OF PRODUCTION 29 EXAMPLE 2: Average Total Cost $170 n/a ATC $ $70$100 n/a AVCAFCTCQ Average total cost (ATC) equals total cost divided by the quantity of output: ATC = TC/Q Also, ATC = AFC + AVC
THE COSTS OF PRODUCTION 30 Usually, as in this example, the ATC curve is U-shaped. $0 $25 $50 $75 $100 $125 $150 $175 $ Q Costs EXAMPLE 2: Average Total Cost $170 n/a ATC $1000 TCQ
THE COSTS OF PRODUCTION 31 EXAMPLE 2: The Various Cost Curves Together AFC AVC ATC MC $0 $25 $50 $75 $100 $125 $150 $175 $ Q Costs
A C T I V E L E A R N I N G 3 Calculating costs 32 Fill in the blank spaces of this table VC $60.00$101 n/a $500 MCATCAVCAFCTCQ $10
A C T I V E L E A R N I N G 3 Answers 33 Use AFC = FC/Q Use AVC = VC/Q Use relationship between MC and TC Use ATC = TC/Q First, deduce FC = $50 and use FC + VC = TC $0 VC $60.00$10$ n/a $500 MCATCAVCAFCTCQ $10
THE COSTS OF PRODUCTION 34 $0 $25 $50 $75 $100 $125 $150 $175 $ Q Costs EXAMPLE 2: Why ATC Is Usually U-Shaped As Q rises: Initially, falling AFC pulls ATC down. Eventually, rising AVC pulls ATC up. Efficient scale: The quantity that minimizes ATC.
THE COSTS OF PRODUCTION 35 EXAMPLE 2: ATC and MC ATC MC $0 $25 $50 $75 $100 $125 $150 $175 $ Q Costs When MC < ATC, ATC is falling. When MC > ATC, ATC is rising. The MC curve crosses the ATC curve at the ATC curves minimum.
THE COSTS OF PRODUCTION 36 Costs in the Short Run & Long Run Short run: Some inputs are fixed (e.g., factories, land). The costs of these inputs are FC. Long run: All inputs are variable (e.g., firms can build more factories, or sell existing ones). In the long run, ATC at any Q is cost per unit using the most efficient mix of inputs for that Q (e.g., the factory size with the lowest ATC).
THE COSTS OF PRODUCTION 37 EXAMPLE 3: LRATC with 3 factory Sizes ATC S ATC M ATC L Q Avg Total Cost Firm can choose from 3 factory sizes: S, M, L. Each size has its own SRATC curve. The firm can change to a different factory size in the long run, but not in the short run.
THE COSTS OF PRODUCTION 38 EXAMPLE 3: LRATC with 3 factory Sizes ATC S ATC M ATC L Q Avg Total Cost QAQA QBQB LRATC To produce less than Q A, firm will choose size S in the long run. To produce between Q A and Q B, firm will choose size M in the long run. To produce more than Q B, firm will choose size L in the long run.
THE COSTS OF PRODUCTION 39 A Typical LRATC Curve Q ATC In the real world, factories come in many sizes, each with its own SRATC curve. So a typical LRATC curve looks like this: LRATC
THE COSTS OF PRODUCTION 40 How ATC Changes as the Scale of Production Changes Economies of scale: ATC falls as Q increases. Constant returns to scale: ATC stays the same as Q increases. Diseconomies of scale: ATC rises as Q increases. LRATC Q ATC
THE COSTS OF PRODUCTION 41 How ATC Changes as the Scale of Production Changes Economies of scale occur when increasing production allows greater specialization: workers more efficient when focusing on a narrow task. More common when Q is low. Diseconomies of scale are due to coordination problems in large organizations. E.g., management becomes stretched, cant control costs. More common when Q is high.
THE COSTS OF PRODUCTION 42 CONCLUSION Costs are critically important to many business decisions, including production, pricing, and hiring. This chapter has introduced the various cost concepts. The following chapters will show how firms use these concepts to maximize profits in various market structures.
CHAPTER SUMMARY Implicit costs do not involve a cash outlay, yet are just as important as explicit costs to firms decisions. Accounting profit is revenue minus explicit costs. Economic profit is revenue minus total (explicit + implicit) costs. The production function shows the relationship between output and inputs. 43
CHAPTER SUMMARY The marginal product of labor is the increase in output from a one-unit increase in labor, holding other inputs constant. The marginal products of other inputs are defined similarly. Marginal product usually diminishes as the input increases. Thus, as output rises, the production function becomes flatter, and the total cost curve becomes steeper. Variable costs vary with output; fixed costs do not. 44
CHAPTER SUMMARY Marginal cost is the increase in total cost from an extra unit of production. The MC curve is usually upward-sloping. Average variable cost is variable cost divided by output. Average fixed cost is fixed cost divided by output. AFC always falls as output increases. Average total cost (sometimes called cost per unit) is total cost divided by the quantity of output. The ATC curve is usually U-shaped. 45
CHAPTER SUMMARY The MC curve intersects the ATC curve at minimum average total cost. When MC ATC, ATC rises as Q rises. In the long run, all costs are variable. Economies of scale: ATC falls as Q rises. Diseconomies of scale: ATC rises as Q rises. Constant returns to scale: ATC remains constant as Q rises. 46
THE COSTS OF PRODUCTION 47 The Complete Data for Example $170$70$ n/a $100$0$1000 MCATCAVCAFCTCVCFCQ $70